April 5, 2009

Types of letters of credit

Confirmed letter of credit In the event of a confirmed letter of credit, the confirming bank (in addition to the issuing bank) assumes an obligation to pay the seller for the goods upon the fulfilment of the conditions of the documentary credit. A confirmed letter of credit gives the seller a two-fold guarantee (opening bank and confirming bank) that the payment will be made. A confirmed letter of credit is mostly used when the seller has reservations about the buyer’s bank or the country of origin of the buyer’s bank. Transferable letter of credit Transferable letter of credit gives the intermediary (the first beneficiary of the letter of credit) an opportunity to apply to the bank for a transfer of the documentary credit for the benefit of the supplier (seller, second beneficiary of the letter of credit). Thus, the intermediary buys the goods from the supplier with the same documentary credit that the intermediary sells the goods with to the buyer. The intermediary transfers its right to the documentary credit amount paid against documents that are in accordance with the conditions of the documentary credit to the supplier. The conditions of documentary credit, specified by the buyer i.e. the party opening the letter of credit, have to be fulfilled and the documents submitted by the supplier. The intermediary exchanges only the supplier’s invoice and the bill of exchange upon receipt of the documentation to the transferring bank (provided that the bill of exchange is required under the letter of credit). Therefore, the main task of the intermediary is to agree upon similar terms and conditions with both its buyer and the seller (with the exception of price), as the second beneficiary of the letter of credit or the seller must meet the terms stated by the buyer in the letter of credit. The letter of credit is transferred in its original form. The first beneficiary of the letter of credit (the intermediary) has the right to change only the following terms upon the transfer of the documentary credit: * documentary credit amount; * price charged for goods (unit price); * expiry date of the letter of credit; * last date for the delivery of goods; * date for presentation of documents. All the aforementioned amounts can be decreased and the deadlines shortened. Also, the intermediary may increase the insurance amount so as to assure the compliance of the insurance with the provisions stated in the original documentary credit. What are the benefits of transferable documentary credit for the intermediary? * Transferable documentary credit is an opportunity to intermediate large trade transactions without having to use one’s own funds (no need for credit decision); * If the terms stated in the documentary credit allow partial shipments, the intermediary may transfer the documentary credit to a number of other beneficiaries of the documentary credit). Back-to-back letter of credit Back-to-back documentary credit is used in situations where a transferable documentary credit cannot or is not allowed to be used for some reason. Upon the intermediary’s request the bank issues a back-to-back documentary credit in favour of the supplier. The documentary credit, opened by intermediary’s bank, is based on documentary credit (so-called initial documentary credit) previously opened in favour of the intermediary. Legally, these are two independent documentary credits; therefore, contrary to the transferable documentary credit, the bank may require the intermediary to provide additional security for the issuing of a back-to-back documentary credit (as the initial documentary credit is not a 100% security for a bank). At the same time the use of back-to-back documentary credit allows the intermediary to avoid direct contacts between the buyer and the seller. Red clause letter of credit A red clause documentary credit includes a special condition that allows the seller to receive a part of the documentary credit amount as an advance payment before the fulfilment of all the conditions stated in the documentary credit. This type of documentary credit is used when the seller needs funds for the purchase, manufacture, or transport of goods. The buyer guarantees the advance payment, thus in order to use a red clause documentary credit the buyer should trust the seller. Revolving letter of credit A revolving documentary credit is suitable for making payments for regular deliveries made over a longer period of time. The buyer asks his bank to issue a letter of credit with a so-called ‘revolving clause’ that allows the seller to present documents to the bank after a certain period of time defined in the documentary credit, submitting then under the same documentary credit without the buyer having to make any amendments. Stand-by letter of credit A stand-by documentary credit is very similar to a bank guarantee; therefore, we are actually speaking of a guarantee instrument. With a stand-by documentary credit, the buyer is required to pay for the goods or services outside the documentary credit. The documentary credit will be used, i.e. the seller will present stipulated documents to the bank only in case the buyer does not fulfil his contractual obligations. The documents required under a stand-by documentary credit usually include only a copy of invoice sent to the buyer and the seller’s written claim to the bank, stating that the buyer has not fulfilled his contractual obligations. The advantage of a stand-by documentary credit over a bank guarantee is the fact that stand-by documentary credits are handled similarly to other types of documentary credits, according to the procedures provided by Uniform Customs and Practice for Documentary Credits (UCP 500), issued by the International Chamber of Commerce. Thus in case of a stand-by documentary credit the bank checks whether the documents presented comply with the provisions of the documentary credit and does not monitor the actual transaction taking place or whether the parties fulfil their contractual obligations or not.